CHAPTER 5
LEARNING OBJECTIVES
1. EXPLAIN VARIABLE, FIXED, AND MIXED COSTS AND
THE RELEVANT RANGE.
2. APPLY THE HIGH-LOW METHOD TO DETERMINE THE
COMPONENTS OF MIXED COSTS.
CHAPTER REVIEW
Cost Behavior Analysis
1. (L.O. 1) Cost behavior analysis is the study of how specific costs respond to changes in the
level of business activity. A knowledge of cost behavior helps management plan operations and
decide between alternative courses of action.
Variable and Fixed Costs
3. (L.O. 1) Variable costs are costs that vary in total directly and proportionately with changes in
the activity level. Examples of variable costs include direct materials and direct labor, cost of
goods sold, sales commissions, and freight-out. A variable cost may also be defined as a cost that
remains the same per unit at every level of activity.
Relevant Range
5. The range over which a company expects to operate during the year is called the relevant range.
Mixed Costs
6. (L.O. 2) Mixed costs are costs that contain both a variable element and a fixed element; they
7. The high-low method uses the total costs incurred at the high and low levels of activity. The
difference in costs represents variable costs, since only the variable cost element can change as
activity levels change.
8. The steps in computing fixed and variable costs under the high-low method are:
a. Determine variable cost per unit from the following formula:
Cost-Volume-Profit Analysis
9. (L.O. 3) Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and
volume on a company’s profits. It is a critical factor in such management decisions as profit
planning, setting selling prices, determining product mix, and maximizing use of production facilities.
Basic CVP Components
11. The following assumptions underlie each CVP analysis:
a. The behavior of both costs and revenues is linear throughout the relevant range of the
activity index.
Contribution Margin
12. Contribution margin is the amount of revenue remaining after deducting variable costs. The
formula for contribution margin per unit is:
Unit Selling
–
Unit Variable
=
Unit Contribution
Price
Costs
Margin
=
Unit Contribution
Margin
Unit Contribution
=
Break-Even Analysis
14. (L.O. 4) The break-even point is the level of activity at which total revenue equals total costs
(both fixed and variable). Knowledge of the break-even point is useful to management when it
decides whether to introduce new product lines, change sales prices on established products, or
enter new market areas.
15. A common equation used for CVP analysis is as follows:
18. The formula using the contribution margin is:
Fixed
÷
Contribution
=
Break-even
Costs
Margin Ratio
Point in Dollars
19. A chart (or graph) can also be used as an effective means to determine and illustrate the break–
even point. A cost-volume-profit (CVP) graph is as follows:
900
800
700
Sales Line
Total Cost Line
Dollars (000)
Target Net Income
20. (L.O. 5) Target net income is the income objective for individual product lines. The following
equation is used to determine target net income sales:
Required Sales – Variable Costs – Fixed Costs = Target Net Income
21. Using the contribution margin technique, we can compute in either units or dollars the sales
required to meet a target net income. To compute the sales required in units the following formula
is used:
Margin of Safety
22. Margin of safety is the difference between actual or expected sales and sales at the break-even
point.
a. The formula for stating the margin of safety in dollars is:
LECTURE OUTLINE
A. Cost Behavior Analysis.
1. Cost behavior analysis is the study of how specific costs respond to
changes in the level of business activity.
3. Variable costs are costs that vary in total directly and proportionately
with changes in the activity level. A variable cost remains the same per
unit at every level of activity.
4. Fixed costs are costs that remain the same in total regardless of changes
in the activity level.
MANAGEMENT INSIGHT
As the population increases and farmable land becomes more scare, growing food
hydroponically in skyscrapers has been studied as an alternative way to grow food
without incurring some of the common costs associated with farming (transportation
to cities, pesticides, etc.). But, even while some costs are reduced by farming
hydroponically, other costs are likely to increase.
What are some of the variable and fixed costs that are impacted by hydroponic
farming?
Answer: Compared to traditional methods, hydroponic farming would reduce
the use of pesticides, herbicides, fuel, and water. Soil erosion would
be eliminated, and land requirements would drop. But, fixed costs
related to constructing greenhouses, suitable vertical planters, as well
as investments in artificial lighting could be high.
5. The relevant range is the range of activity over which a company expects
to operate during a year. It is important in CVP analysis because the
MANAGEMENT INSIGHT
The recent recession produced a surprise for some manufacturers— the number of
jobs lost was actually lower than in previous recessions. In the years preceding
the recession, many factories adopted lean manufacturing practices that relied
less on large numbers of low skilled workers, and more on machines and a few
highly skilled workers. Because the employees are highly skilled, employers are
reluctant to lose them.
Would you characterize labor costs as being a fixed cost, a variable cost, or
something else in this situation?
Answer: Because these labor costs are essentially unchanged for most levels
of production, they are primarily fixed. However, it could be described
B. Cost-Volume-Profit Analysis.
1. Cost-volume-profit (CVP) analysis is the study of the effects of changes
in costs and volume on a company’s profits. CVP analysis is important in
profit planning. It is useful in setting selling prices, determining product
mix, and maximizing use of production facilities.
2. CVP analysis considers the interrelationships among the following
components:
a. Volume or level of activity.
b. Unit selling prices.
c. Variable cost per unit.
3. The following assumptions underlie each CVP analysis:
a. The behavior of both costs and revenues is linear throughout the
relevant range of the activity index.
b. Costs can be classified accurately as either variable or fixed.
c. Changes in activity are the only factors that affect costs.
4. Contribution margin is the amount of revenue remaining after deducting
variable costs. It can be expressed as a per unit amount or as a ratio.
a. Unit Contribution Margin = Unit Selling Price – Unit Variable Costs.
C. Break-even Analysis.
1. At the break-even point, the company will realize no income but will
suffer no loss.
2. Knowledge of the break-even point is useful to management when it
decides whether to introduce new product lines, change sales prices on
established products, or enter new market areas.
3. The break-even point can be:
a. Computed from a mathematical equation: Sales – Variable Costs –
Fixed Costs = Net Income. In the case of the break-even point, we
set the net income equal to zero.
4. The income objective set by management is called target net income. To
meet target net income, required sales must be determined.
a. Mathematical equation: Required Sales – Variable Costs – Fixed
Costs = Target Net Income. Required sales may be expressed in
either sales units or sales dollars.
b. Contribution margin technique: (Fixed Costs + Target Net Income)
÷ Contribution Margin Ratio = Required Sales in Dollars.
SERVICE COMPANY INSIGHT
FlightServe, a chartered aircraft company, decided to match up executives with
charter flights in small “private jets”. The company noted that the average charter
jet had eight seats, but it would break even at an average of 3.3 seats per flight.
How did FlightServe determine that it would break even with 3.3 seats full per flight?
Answer: FlightServe determined its break-even point with the following formula:
Fixed costs ÷ Contribution margin per seat occupied = Break-even
point in seats.
MANAGEMENT INSIGHT
The promoter for the Rolling Stones’ tour guaranteed $1.2 million to the group. In
addition, 20% of the gross goes to the stadium where the performance is staged
and another $400,000 for other expenses such as ticket takers and advertising.
What amount of sales dollars are required for the promoter to break even?
Answer: Fixed costs = $1,200,000 + $400,000 = $1,600,000
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. The range over which a company is expected to operate is called the relevant range of
the activity index.
True False
2. A mixed cost contains both selling and administrative cost elements.
True False
3. Variable costs are costs that remain the same per unit at every level of activity.
True False
4. If a salesperson incurs $2,000 of expenses in servicing two customers and $4,000 of
expenses in servicing four customers, the fixed costs are $1,000.
True False
5. If revenue = $80 and variable cost = 40% of revenue, then contribution margin = $48.
True False
6. The contribution margin is the amount of revenue remaining after deducting fixed costs.
True False
7. Sales mix is the percentage that each product represents of total sales.
True False
8. If the unit contribution margin is $300 and fixed costs are $240,000 then the break-even
point in units would be 800 units.
True False
9. In a CVP income statement, contribution margin is reported in the body of the statement.
True False
10. Margin of safety is the difference between actual sales and contribution margin.
True False
Multiple Choice
1. Which of the following is a false statement regarding assumptions of CVP analysis?
a. Total fixed costs remain constant over the relevant range.
b. Unit selling prices are constant.
c. Changes in volume or level of activity increase variable costs per unit.
d. All units produced are sold.
2. Mixed costs may be separated into fixed costs and variable costs by using
a. the relevant range method.
b. the high-low method.
c. the contribution margin method.
d. all of the above.
3. If the unit selling price is $500, the unit variable cost is $300, and the total monthly fixed
costs are $300,000, then the contribution margin ratio is
a. 30%.
b. 40%.
c. 50%.
d. 60%.
4. If activity level increases 25% and a specific cost increases from $40,000 to $50,000, this
cost would be classified as a
a. variable cost.
b. mixed cost.
c. fixed cost.
d. none of the above.
5. If total fixed costs are $900,000 and variable costs as a percentage of unit selling price
are 40%, then the break-even point in dollars is
a. $1,500,000.
b. $360,000.
c. $2,250,000.
d. not determinable with the information given.
ANSWERS TO QUIZ
True/False
1. True 6. False
Multiple Choice
1. c.